5 Capital Budgeting Techniques Used by Accountants
Accountants apply capital budgeting techniques as a method for evaluating the potential benefits and risks of large expenses. These include long-term ventures and assets, such as acquiring new land and equipment or building new facilities, with the central goal of yielding greater returns and increasing shareholder value. The following overview of capital budgeting techniques shows the benefits and drawbacks of each method.
Net present value
Determining the net present value is one of the most efficient capital budgeting techniques, both mathematically and in terms of a time value of money perspective. This method analyzes the forecasted cash flow of a project by discounting the cash flows to the present, factoring in the time span of the project and the weighted average cost of capital.
If the net present value is positive, the business is encouraged to make the investment or undertake the new project; however, the opposite is true if the result turns out negative. Understanding the type of project to be evaluated is the first step to making decisions based on the net present value. Independent projects, which are not affected by other projects’ cash flows should be accepted if the net present value is greater than $0. Mutually exclusive projects represent projects where there are two ways of accomplishing the same ends and, in this case, the project with the greater net present value should be accepted. If the net present value of both projects is negative, then both should be rejected.
The simplicity of the payback period technique makes for a quick budgeting analysis, though there are several deficiencies businesses should be aware of. The payback period is the amount of time it takes for the initial investment of a project to be paid back. Businesses use this method to decide whether or not to invest in a capital project based on the length of time it takes to recoup their initial investment. If the payback period is too long, they will likely not purchase the asset or invest in the project. One of the main deficiencies of this method is that it does not account for the time value of money, which means cash inflows that will be received in the future hold the same weight as those received in the first year. It does provide a quick rough estimate of when an investment will be paid back and can be used as a jumping-off point before employing more advanced capital budgeting techniques.
Accounting Rate of Return (ARR)
The accounting rate of return signifies a percentage value showing the rate of benefits that an asset can generate over its lifespan. Accountants determine the figure by dividing a fixed asset’s net income by its average book value, then multiplying that number by 100. Management determines the ARR for an investment and if the result fits within the established value, then the asset or investment is accepted. Similar to the payback period method, the ARR does not factor in the time value of money and cash flow timing. Also, the ARR does not account for the impact a capital project may have on the business overall as well as increased risks and other variables associated with long-term investments.
Internal Rate of Return (IRR)
This application represents the discount rate resulting in a net present value of zero and is used to analyze actual or potential investments that have varied over time. The IRR is commonly used for project analysis to figure out whether or not managers or investors should embark on a specific project. It is often used in presentations for those without financial backgrounds because it is easier to understand. The limitation of this type of forecasting is that it is more conceptual and does not address scale, which is important for determining real dollar amounts.
Another technique of capital budgeting involves comparing the value of costs and the value of the proposed project’s benefits. This is known as the profitability index, which is calculated by dividing the initial investment by the current value of a project’s future cash flows. If the profitability index is greater than 1.0, the profitability is positive and the project is likely a good investment. If it is less than 1.0, the proposed project will lose value. A profitability index equaling 1.0 indicates that the projects cash gains or losses will be minimal.
In order to advise business owners properly regarding undertaking capital projects, accountants must make use of a variety of budgeting methods. Knowing when to use these techniques is an integral part of an their job. These and other capital budgeting techniques are necessary functions that accountants can use to identify and recommend profitable investments for organizations.
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